Q3/2008 Market Review ~ Bubbles, Crashes & Recoveries!
October 16, 2008
Welcome to the Kalorama Wealth Strategies Quarterly Market Review. These
quarterly briefs update the performance of the financial markets and provide
commentary on topics affecting investments.
Buyouts, bailouts, and bankruptcies! The second half of 2008 will certainly be
enshrined in the annals of financial history, with the U.S. Treasury, Federal
Reserve, Securities and Exchange Commission, and Congress taking unprecedented
actions to address the disarray in financial markets, and beginning to
ultimately address an obsolete regulatory framework which is insufficient to
address modern-day financial instruments and markets.
The bears continued growling on Wall Street at the outset of the third quarter,
quieted down by mid July, hibernated in August, and left the cave with a
vengeance in September. The July recovery came when the federal government
signaled it would provide a backstop to mortgage-behemoths Fannie Mae and
Freddie Mac. By September, the implicit guarantee became explicit when both
companies were placed into government conservatorship.
The capital markets turmoil forever changed the financial industry landscape.
The upheaval yielded the buyout of Merrill Lynch by Bank of America in a 100%
stock deal, the bankruptcy of investment banking firm Lehman Brothers Holdings
Inc., the failure of Washington Mutual Bank (and the sale of its assets to JP
Morgan Chase & Co.), the bailout by the Feds of insurance-giant American
International Group (AIG) (wherein the government took a 79.9% stake in AIG in
exchange for a loan from the Federal Reserve for as much as $85 billion, with
another $38 billion advanced in October), and the merger of financial services
firm Wachovia Corp. into Wells Fargo. The collapse of Lehman Brothers and
Washington Mutual were the largest bankruptcy and bank failure, respectively, in
U.S. history.
In the meantime, although the Federal Reserve left its discount rate unchanged
at 2.0% at both of its meetings during the quarter, it provided additional
liquidity by increasing its lending facilities and expanding the type of
collateral it would accept from borrowers. Investor fear and anxiety drove
investors to the relative safety of Treasury securities. At one point, the rally
pushed the yield on the 10-year Treasury Note below 3.40%. However, as stocks
made fitful attempts to recover, at quarter end, the yield on the 10- year
Treasury Note was just 16 basis points lower to close at 3.82% (the yield as of
October 15th was 3.95%).
On the penultimate day of the quarter, stocks were bludgeoned as Congress failed
to pass legislation designed to unclog credit markets (the $700 billion act was
subsequently signed into law on October 3rd). Major-market barometers suffered
their worst one-day percentage losses since September 2001 and point-declines in
history. Stocks recovered a bit on the final day of the period, but the
quarter's story was already written, as the instability left both stocks and
bonds severely pummeled.
There was almost no place to hide during the quarter, with the only bright spot
being Domestic Small Cap Value stocks, rising 5.0%. All other equity indices
were in negative territory. With the dollar strengthening during the period,
international stocks felt the brunt of the carnage, tumbling by double-digits.
Year-to-date, all equity indices are off by double-digits, again with the
exception of Domestic Small Cap Value, shrinking only 5.4%. Typically a safe
haven during periods of market disorder, key bond indices also posted
across-the-board declines.
Subsequent to quarter end, as the credit market mayhem spread to international
markets, stocks around the world plummeted (see Bubbles, Crashes & Recoveries
below). On October 8th, in a coordinated global effort, the U.S. Federal Reserve
and six other central banks lowered interest rates. In the U.S., the Fed dropped
the Fed Funds and Discount Rate by 50 basis points to 1.50% and 1.75%,
respectively.
Below are rates of return for selected market indices for the third quarter of
2008, year-to-date 2008, and the three, five, and 10-year compound annual
returns as of December 31, 2007.
Bubbles, Crashes & Recoveries!
Savings and investment bank failures, commercial paper markets freezing, money
market funds "breaking the buck," and credit default swaps imploding. The
genesis of the crisis in financial markets was the bursting of the housing
bubble. Soaring home prices were driven by baseless demand created by unlimited
lending to unqualified borrowers. The affect of homeowner delinquencies and
defaults on the value of mortgage backed securities and derivatives resulted in
systemic liquidity failures.
With the severity of calamities and the resulting re-pricing of assets, all
market participants are in un-chartered territory. The federal government
continues to use every monetary solution at its disposal to address the market
disruptions. (Is the kitchen sink next? Unsubstantiated rumors around Washington
say they are collecting kitchen sinks at the U.S. Treasury as a substitute
container for Hoover's "chicken in every pot"!) Not since the Great Depression
of the 1930s have market conditions prevailed which would require the government
to intervene at such a level to address capital-market liquidity issues.
Meanwhile, whether you realize it, you have lived through a global stock market
crash. Unlike 1987, when U.S. stocks collapsed more than 20% in one day, this
crash was in slow motion over a couple of weeks. At the close of trading on
October 10th, U.S. stocks had retreated more than 20% over eight consecutive
trading sessions. Coincidentally, October 9th marked the one-year anniversary of
market bellwethers hitting their all-time highs: the Dow Jones Industrial
Average and the Standard & Poor's 500-Stock Index had closed at 14,164.53 and
1,565.15, respectively. A year and a day later, the Dow Jones shrank more than
41% to 8,451.19 and the S&P 500 plunged 43% to 899.22.
Although an economic recession is probably unavoidable at this juncture, many
are asking whether 2008 will be the beginning of another Great Depression.
Hopefully not; the Great Depression generated 25% unemployment and bank
depositors lost their life savings. Probably not; the 1930's chaos shaped
today's federal insurance for bank deposits, Social Security and Medicare for
the elderly, unemployment insurance, and other safety nets.
Today's national unemployment rate is 6.1%. The U.S. has endured 10 post-World
War II recessions with average peak unemployment of 7.6%. The worst slumps
occurred in 1973-75 and 1981-82, with peak unemployment of 9.0% and 10.8%,
respectively. Further, the Depression's economic malaise was escalated by
contrary government actions which led to the banking collapse and a devastating
drop in the money supply. To the Federal Reserve's benefit, the concept of
monetary policy had not yet been fully developed.
Now that it appears the dust is settling, perhaps it is the time to review past
crashes and recoveries. The whopper, of course, was the 1929 crash and
subsequent depression. As measured by the Dow Jones Industrial Average, it took
stocks 25 years until 1954 to recover from the 1929 crash (the lowest point was
actually reached in 1932). Again, perhaps not the most relevant based on the
government policies and actions of that era.
There have been 10 previous post-war bear markets, which are defined as declines
of at least 20% in the S&P 500. The average slump was 31.5%. More recently, the
S&P 500 spent about five years retracing the 50% slide from the 2000-2002
aftermath of the tech-bubble. During the October 1987 retrenchment, the Dow
Jones was able to completely recover within two years. In addition, the S&P 500
retreated 30% in the three-month period ending November 1987, and rebounded 23%
over the next 12 months.
What's a long-term investor to do? First, don't panic; although past performance
does not guarantee future results, historically all bear markets have come to an
end and have been followed by a recovery. Also, markets tend to over-extend on
the upside and downside. Second, stick to your plan or strategy. If you've
created a sound plan to achieve your financial goals, you should maintain your
long-term strategy. Furthermore, don't stop contributing to your retirement or
other accounts. Remember, its buy low and sell high, not sell low and buy high!
In addition, maintain a well-diversified portfolio and periodically rebalance to
make sure the asset allocation is consistent with your risk tolerance.
If you are not sure whether your portfolio is adequately structured to benefit
from a future recovery, Kalorama Wealth Strategies can help you create an
investment plan to achieve your financial goals. For more information, please
see our web site at
www.kaloramawealth.com.
Thank you for your business, trust, and referrals. Please feel free to forward
this email to friends and colleagues who can benefit from information about
investing and financial planning. If I can be of any assistance to you or anyone
you know, please do not hesitate to contact me.
Sincerely,
David
P.S. - Happy Anniversary! September 30, 2008 marked the third anniversary of the
official launch of Kalorama Wealth Strategies! Thank you for your support.
_____________________________________
David M. Taube, CPA, CFA, CFP®, CRI
Founder and President
Kalorama Wealth Strategies
202-550-7262
